If you know us, you know that we love the Roth IRA, Roth 401k and cash value life insurance. Using these tools, you will have generally already paid taxes at some historically low rates, will not have future RMDs, and will have all future earnings returned to you tax free.
If you are considering a Roth conversion one technique is to attempt to fill up lower tax brackets. Your idea of a lower tax bracket is a relative term and will be different for every family. But for many, doing a conversion even into the 22% to 24% brackets can make sense. Often, an attractive window to do conversions is the window after retirement but before you begin RMDs.
We can run a simulation that projects your income throughout retirement and that assumes sunsetting of the TCJA. The simulation will project the tax bracket and effective tax rate you will be in each year throughout your lives. When we run this analysis, we can determine where we believe are the optimal years to do a conversion. Often, it’s in that retirement to RMD window.
Here is an example couple to consider. Assume a married couple right now who have a seven-year age gap and plan to retire at age 58 and 65. They each could do some conversions from retirement until RMDs begin. They will be able to do some of those conversions in the 15% bracket which looks like a good deal compared to their working years and when they both are taking RMDs. In their case – we do not want that window from retirement to RMDs to leave any money on the table within the 15% tax bracket. We want to fill those lower brackets completely up. In their case, doing conversions even into the 25% bracket makes sense as the RMDs are projected to be so big in later years that they go into the 28% bracket towards the end of the older spouse’s life expectancy. The age difference of seven years brings the widow penalty into effect which shows that if we assume the younger spouse outlives the older spouse, we could have the last seven years of life expectancy for the younger surviving spouse in the 33% bracket due to having to switch to a single tax filer.
Graphically, the picture of lifetime taxes is like a U. Higher taxes and brackets while you’re working, a trough or the bottom of the U when you’re retired but before RMDs, then going back up the U slope once you’re in RMD territory. This is simplified of course… but if you’re in your peak earning years and in a high bracket while working it may be tough to want to do conversions. Likewise, if you have big RMDs later in life doing conversions could again be difficult. This leads to the sweet spot in those years from retirement to RMD time.
When we run this projection it’s amazing to see couples that move into some high tax brackets as they progress through retirement. Some are in the 22% to 25% tax brackets while working and they end up in the 28% to 33% bracket in retirement all due to big RMDs. Showing this analysis can feel shocking for many people because it dispels the common thought that retired folks will be in lower tax brackets when retired. That can be the case early, but not if you have big IRA’s. Hitting up conversions in the window before RMDs helps smooth out the taxes over time and leads to lower overall taxes being paid over one’s lifetime and leads to a higher net worth over time.
Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.